CHAPTER 3—THE BASICS OF ADJUSTING ENTRIES

Study Objectives—after studying the chapter, you should be able to:

1. Explain the time period assumption.
2. Explain the accrual basis of accounting.
3. Explain why adjusting entries are needed.
4. Identify the major types of adjusting entries.
5. Prepare adjusting entries for deferrals (prepayments).
6. Prepare adjusting entries for accruals.
7. Describe the nature and purpose of an adjusted trial balance.
8. Prepare adjusting entries for the alternative treatment of prepayments.

INTRODUCTION: Take the following Quiz on Adjusting Entries and then

check the answers on the last page of the lecture notes after you have
studied this chapter:

1. T or F: Adjusting entries are made to apply the matching principle.

2. T or F: The Cash account is found in some adjusting entries.

3. T or F: All adjustments affect both the Balance Sheet and the Income
Statement.

Matching from types of Adjusting Entries: (1) Accrued expense; (2)

Accrued revenue; (3) Deferred expense; and (4) Deferred revenue:

4. ____ Unpaid salaries

5. ____ Rent received in advance

6. ____ Prepaid insurance

7. ____ Interest earned but not received

8. ____ Rent paid in advance

9. ____ Subscriptions received in advance

10.____ Rent due to us

11. ____ Unpaid interest

I. Definitions and Key Concepts—the Accrual Basis Accounting applies these

principles:
A. Define the cash basis and the accrual basis of accounting :

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 1. Cash basis—an accounting method in which an expense is recorded when
cash is paid and revenue is recorded when cash is received. Cash-basis
accounting is NOT in accordance with GAAP.
2. Accrual basis—an accounting method in which an expense is recorded
when it is incurred and revenue is recorded when it is earned. It is the basis
of accounting in which transactions that change a company’s financial
statements are recorded in the periods in which the events occur.

B. Define the matching principle.

1. Matching principle—the accounting principle that states that revenue
earned during an accounting period should be offset by the expenses that were
incurred in earning that revenue. The principle that efforts (expenses) be
matched with accomplishments (revenues).
2. How to apply the matching principle—at the end of the accounting
period expenses and revenues must be examined to find out what amounts
belong to the period regardless of when the related cash payments and receipts
occur which means you will need to adjust both expenses and revenues in
order to apply the matching principle.
3. To determine Accrual Net Income:
All Recognized Revenues
All Matched Expenses
Recognized Revenues - Matched Expenses = Accurate net income for the period

C. Define the time period assumption:

1. An assumption that the economic life of a business can be divided into
artificial time periods.
2. Owners and managers as well as other users need timely results of
operations of a business:
a) Management usually wants monthly financial statements.
b) Internal Revenue Service (IRS) requires all businesses to file
annual tax returns.
D. Fiscal and Calendar Years:
1. Accounting time periods are generally a month, a quarter, or a year.
Monthly and quarterly time periods are called interim periods—less than
one year.
2. Fiscal year—an accounting period that is one year in length. A fiscal year
usually begins on the first day of a month and ends twelve months later on
the last day of a month.
3. Calendar year—an accounting period that extends from January 1 to
December 31.
E. Define the revenue recognition principle: The principle requires companies
to record revenue when (or as) the entity satisfies each performance obligation
in a five step process:
1. Identify the contract with the customer which is an agreement between
two or more parties that creates enforceable rights and obligations.

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 2. Identify the performance obligations in the contract which are
contractual promises with a customer to transfer a good or service.
3. Determine the transaction price (amount entity expects to be entitled).
4. Allocate the transaction price to the performance obligations in the
contract.
5. Recognize revenue when (or as) the entity satisfies each performance
obligation by transferring a good or service to a customer which is when
customer obtains control of the good or service and amount recognized is
amount allocated to the satisfied performance obligation.
F. Define accruals and deferrals .
1. Accruals—Expenses incurred and revenue earned in the current
accounting period but not recorded as of the end of the period. To accrue
means to build up or to accumulate. Thus, an accrual is a buildup or
accumulation of revenue or an expense that has not been recorded by a
routine journal entry.
2. Deferrals—Expenses and revenues that have been recorded in the
current accounting period but are not incurred or earned until a future
period. To defer means to put off or to postpone. Thus a deferral is a putting
off or a postponement of revenue or an expense that has been recorded by a
routine journal entry but belongs to the future.
G. Define the Going Concern Concept —financial reports of a business are
prepared with the expectation that the business will remain in operation
indefinitely. Since this concept assumes that a business will continue indefinitely
into the future, by accruing expenses and revenues, it is understood that the
business has a future.
H. The Basics of Adjusting Entries:
1. Adjusting entries are entries made at the end of an accounting period
to ensure that the revenue recognition and matching principles are
followed.
2. Adjusting entries are required every time financial statements are
prepared and are dated as of the balance sheet date.
3. Adjusting entries are needed because:
a) Some events are not journalized daily because it is
inexpedient to do so. Examples are the consumption of supplies and
the earning of wages by employees.
b) Some costs are not journalized during the accounting period
because they expire with the passage of time rather than through
recurring daily transactions. Examples are equipment deterioration,
and rent and insurance expiring.
c) Some items may be unrecorded. An example of a utility bill
that will not be received and/or paid until the next accounting period.
I. Types of Adjusting Entries:
1. Prepayments:
a) Prepaid Expenses—expenses paid in cash and recorded as assets
(or expenses as shown in the chapter appendix—alternative treatment of

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 prepaid expenses) before they are used or consumed. Depreciation of
plant assets falls into this category.
b) Unearned Revenues—cash received and recorded as liabilities
(or revenues as shown in the chapter appendix—alternative treatment of
unearned revenues) before revenue is earned.
2. Accruals:
a) Accrued Revenues—revenues earned but not yet received in
cash or recorded.
b) Accrued Expenses—expenses incurred but not yet paid in cash
or recorded.

II. Accounting for Accrued Expenses—ADJUSTING ENTRIES FOR

ACCRUALS. The accrual of expenses creates liabilities. Expenses that have
been incurred but not yet recorded at the end of an accounting period require an
adjusting entry to recognize both the proper amount of expense for the period on
the income statement and the proper amount of liabilities on the balance sheet.
Accrued Expenses are also called Accrued Liabilities because accrued expenses have
not been paid as of the end of the period and thus represent a liability of the firm.
Helpful hint to remember what is done with Accruals: The “A” in Accrual means
add to expense or revenue as the adjusting entry will be adding to expenses or to
revenues.

A. Explain ACCRUED SALARIES and the adjustment needed:

1. How accrued salaries occur—accrued salaries occur only when the last
day of the payroll period and the last day of the accounting period are
different days.
2. Steps to accrue salaries:
a. Determine the days to accrue: BE CAREFUL determining the
number of days to accrue salaries. Best way to determine the number
of days to accrue is to set up a calendar of the week and notate what
day the year ends. YOU ARE ACCRUING THE EXPENSE FOR
THE CURRENT YEAR (2014) NOT THE FOLLOWING YEAR
(2015). If $20,000 is the weekly payroll, the daily amount for a five-
day work week would be $4,000:
2014 2015
Dec. 29 30 31 Jan. 1 2
Monday Tuesday Wednesday Thursday Friday Total
$4,000 $4,000 $4,000 $4,000 $4,000 $20,000
$12,000 is Accrued $8,000 is NOT Accrued

b. Determine the amount to accrue: $20,000 is total payroll ÷ 5

days = $4,000 per day x 3 days (Dec. 29 – Dec. 31) = $12,000.
c. Prepare the adjusting entry:
General Journal Page 1
Date Account Title P.R. Debit Credit

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 2014 Adjusting Entries
Dec. 31 Salaries Expense 12,000.00
Salaries Payable 12,000.00

3. An adjusting entry, such as one for an accrued expense, affects both the
income statement and the balance sheet) as it results in an increase (debit)
to an expense account and an increase (credit) to a liability account. In the
case of an accrued expense such as accrued salaries, the income statement is
affected because an expense account (Salaries Expense) is debited; a
balance sheet account is affected because a liability account (Salaries
Payable) is credited.

4. Affect if the adjusting entry for accrued expenses is OMITTED:

a. Expenses are understated as did not accrue the additional expense
of Salaries Expense. Set up the accounting equation with simple balances
in the accounts if fail to do the adjustment: A = L + OE + R – E or 200
= 100 + 50 +100 -50. Expenses are showing a balance of $50 but the
balance SHOULD BE (S/B) $60 as an additional expense of $10 should
have been accrued. Therefore expenses are understated by $10 if the
adjusting entry is omitted.
b. Liabilities are understated as did not accrue the additional liability
owed of Salaries Payable. The example of 200 = 100 + 50 +100 -50 is
showing the balances in the accounts if fail to do the adjustment.
Liabilities are showing a balance of $100 but the balance SHOULD BE
(S/B) $110 as an additional liability of $10 should have been accrued.
Therefore liabilities are understated by $10 if the adjusting entry is
omitted.
c. Net income is overstated as did not accrue the additional expense
of Salaries Expense which would reduce the amount of net income as
expenses decrease income and owner’s equity. The accounting equation is
showing a net income of $50 ($100 Revenues - $50 Expenses) if fail to do
the adjustment. When the accrued expense is made the net income is
$40 ($100 Revenues - $60 Expenses). Therefore net income is
overstated by $10 if the adjusting entry is omitted.
5. TYPICAL STUDENT MISCONCEPTION: Students often want to use
the Cash account when making an adjusting entry for an accrual. This
point needs to be emphasized—Cash is NEVER involved in ANY adjusting
entry. The reason is that the Cash account should already be reconciled
BEFORE adjusting entries are made. If an adjusting entry is made to the
Cash account, the account WILL NO LONGER BE RECONCILED to the
balance per the bank statement.

B. Explain accrued interest and the adjustment needed. Helpful hint to

remember what is done with Accruals: The “A” in Accrual means add to
expense or revenue as the adjusting entry will be adding to expenses or to

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 revenues. Thus with accrued interest, additional interest will be added to the
interest expense account.
1. How to calculate the due date of a note:

Determine Due Dates of Notes

(a) 90 days from May 8:
Begin with last day of month that the note was dated May 31
Subtract the date of the note May -8

Days in the first month May 23

Add the total days in the following month June 30 84 days
Add the total days in the following month July 31
Due Date of
Days needed in the next month for a total of 90 days Aug 6 Note
Total days of note 90

2. How to calculate interest: Interest (I): The cost of borrowing money

that accumulates with the pages of time or the charge for credit; calculated
as principal (P) x rate (R) x time (T). Bankers’ interest used to use a 360-
day year if the note is by days but if notes are by months, then the
denominator will use 12 for months in a year. Examples below use the 360-
day year but per textbook now changing to a 365-day year rather than a
360-day year to better reflect how actual lenders calculate interest. It may
be expressed as a fraction of a year in months (number of months/12) or a
fraction of a year I days (number of days/365).
3. Accrued interest arises when the accounting period ends BEFORE THE
NOTE REACHES ITS MATURITY DATE. The interest from day of note
to the end of the accounting period is an expense and a liability and must
be recorded with an adjusting entry.
4. Steps to make an adjusting entry for accrued interest :
a. Determine the days from the date of the note to the end of the
accounting period. Refer to the example: Assume that on November
1, 20--, Bluff City Supply Company borrowed $12,000 on a 90-day,
14% note (the day after the note is signed is the first day when
counting days).
Begin with last day of month that the note was dated Nov. 30
Subtract the date of the note Nov. -1

Days in November Nov. 29

Add the total days in December Dec. 31
Total days from the date of the note to end of period 60
b. Calculate the interest from the date of the note to the end of the
accounting period.
Principal x Rate x Time = Interest
$12,000 X 14% X 60/360 = $280
c. Make the adjusting entry:

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 General Journal Page 1
Date Account Title P.R. Debit Credit
20-- Adjusting Entries
Dec. 31 Interest Expense 280.00
Interest Payable 280.00

d. Post to the General Ledger:

Liabilities Owner's Expenses

Assets = + + Rev. -
Equity
Cash Interest Payable Interest Expense

Dec.31Adj. Dec. 31 Adj.

280 280
5. Affect if the adjusting entry for accrued expenses is OMITTED:
a. Expenses are understated as did not accrue the additional
expense of Interest Expense. Set up the accounting equation with simple
balances in the accounts if fail to do the adjustment: A = L + OE + R –
E or 200 = 100 + 50 +100 -50. Expenses are showing a balance of $50 but
the balance SHOULD BE (S/B) $60 as an additional expense of $10
should have been accrued. Therefore expenses are understated by $10 if
the adjusting entry is omitted.
b. Liabilities are understated as did not accrue the additional
liability owed of Interest Payable. Liabilities are showing a balance of
$100 but the balance SHOULD BE (S/B) $110 as an additional liability of
$10 should have been accrued. Therefore liabilities are understated by
$10 if the adjusting entry is omitted.
c. Net income is overstated as did not accrue the additional
expense of Interest Expense which would reduce the amount of net
income as expenses decrease income and owner’s equity. The accounting
equation is showing a net income of $50 ($100 Revenues - $50 Expenses)
if fail to do the adjustment. When the accrued expense is made the net
income is $40 ($100 Revenues - $60 Expenses). Therefore net income is
overstated by $10 if the adjusting entry is omitted.
C. Describe other types of accrued expenses—the adjusting entry always
involves a debit to an expense and a credit to a liability.
1. To accrue rent that is owed but unpaid at the end of the accounting
period—debit Rent Expense and credit Rent Payable.
2. To accrue taxes that are owed but unpaid at the end of the accounting
period—debit Taxes Expense and credit Taxes Payable.
3. To accrue utilities that are owed but unpaid at the end of the
accounting period—debit Utilities Expense and credit Utilities or Accounts
Payable.

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III. Accounting for Accrued Revenue . The accrual of revenue creates
assets. Accrued revenue has been earned in the current accounting period but the
cash will NOT BE RECEIVED until the next period. Accrued revenue is also called
an Accrued Asset as the debit will be to a Receivable (an asset) account when
accrued revenue is credited). Helpful hint to remember what is done with Accruals:
The “A” in Accrual means add to expense or revenue as the adjusting entry will be
adding to expenses or to revenues in this case. Remember that the goal is to adhere to
the revenue recognition principle—a business earns (realizes) revenue when goods or
services are sold to customers, even though cash may not be collected until sometime
in the future. Therefore, to make sure that the correct amount of revenue is shown that is
earned each fiscal year for the accrual basis of accounting, some revenue may need to
be accrued that has been earned but not yet recorded. Adjusting entries to accrue
revenue will affect both an income statement (credit to a revenue) and a balance sheet
(debit to a receivable) account ALL adjusting entries effect one Income Statement
account and one Balance Sheet account.
A. Explain accrued rent revenue and the adjustment needed.
1. Accrued rent revenue—revenue earned but not yet received.
2. Steps to prepare the adjusting entry:
a. Calculate the amount of rent earned.
b. Prepare the adjusting entry—an adjusting entry for accrued
revenues results in an increase (debit) to an asset account and an
increase (credit) to a revenue:
General Journal Page 1
Date Account Title P.R. Debit Credit
20-- Adjusting Entries
Dec. 31 Rent Receivable 1,200.00
Rent Income 1,200.00
c. Post to the General Ledger where the Rent Receivable will be
shown under the current asset section on the Balance Sheet and Rent
Income account will be closed and its balance listed as nonoperating
revenue on the income statement:

Liabilities + Owner's Expenses

Assets = + Revenues -
Equity
Cash Rent Income
Dec.31 Adj.
1,200
Rent Receivable
Dec.31 Adj.
1,200

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 3. A good way to understand the concept of accrued revenue is the
mirror image concept—accrued revenue is the mirror image of accrued
expenses. A rent accrual can be shown as follows:
a. From the Lessor perspective, the entry would be:
Debit—Rent Receivable 1,200
Credit—Rent Income 1,200
b. From the Lessee perspective, the entry would be:
Debit—Rent Expense 1,200
Credit—Rent Payable 1,200
4. Affect if the adjusting entry for accrued revenues is OMITTED:
a. Revenues are understated as did not accrue the additional revenue
of Rent Income. Set up the accounting equation with simple balances in
the accounts if fail to do the adjustment: A = L + OE + R – E or 200 =
100 + 50 +100 -50.. Revenues are showing a balance of $100 but the
balance SHOULD BE (S/B) $110 as an additional revenue of $10 should
have been accrued. Therefore revenues are understated by $10 if the
adjusting entry is omitted.
b. Assets are understated as did not accrue the additional receivable
owed to the company of Rent Receivable. The accounting equation is
showing the balances in the accounts if fail to do the adjustment.
Assets are showing a balance of $200 but the balance SHOULD BE (S/B)
$210 as an additional receivable of $10 should have been accrued.
Therefore assets are understated by $10 if the adjusting entry is omitted.
c. Net income is understated as did not accrue the additional revenue
of Rent Income which would increase the amount of net income as
revenues increase income and owner’s equity. The net income shows $50
($100 Revenues - $50 Expenses) if fail to do the adjustment. When the
accrued revenue is made the net income is $60 ($110 Revenues - $50
Expenses). Therefore net income is understated by $10 if the adjusting
entry is omitted.
B. Describe other types of Accrued Revenue:
1. In Chapter 8 Notes Receivable are covered and should be considered
as the mirror image of Notes Payable. Calculations of due date and interest
are identical for notes payable and notes receivable and where one company’s
interest expense is another company’s interest income. To accrue interest
income:
a. Calculate interest earned from the date of the note until the
end of the accounting period—P x R x T.
b. Record the adjusting entry:
Debit—Interest Receivable
Credit—Interest Income
2. Any unbilled revenues such as fees earned or sales made but where
the cash has not yet been received needs to be accrued to accounts
receivable. Normally the name of the receivable account will match the
name of the revenue account as shown in the above examples (i.e. Rent
Receivable/Rent Income; Interest Receivable/Interest Income, etc.) unless

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 the revenue is for the regular income for the business. The example of fees
earned, but not yet recorded example:
Debit—Accounts Receivable
Credit—Fees Earned

IV. Summary of Accruals:

A. Accruals ALWAYS Add—the “A” in accrual means Add. You always Add
to expense or Add to revenue (bringing in something not yet recorded into
the present) and you ALWAYS Add to the Balance Sheet (liabilities or assets
and Add to the Income Statement (expenses or revenues).
B. The adjustment for accruals usually (unless you are accruing the service or
sales revenue for the normal operations of the business in which case
accounts receivable is the account) ALWAYS creates a balance sheet account.
C. Accruals can ALWAYS be reversed. This point is a key one before going on to
deferrals, which can only SOMETIMES BE REVERSED. The RULE TO
MASTER: Whenever an adjusting entry creates a Balance Sheet account
(liability or asset) reversal is possible and desirable as well so that the adjusting
entry into the created account WILL NOT BE FORGOTTEN. When the
salaries are paid the following period, the debit to Salaries Payable must be
made along with the amount for Salaries Expense. But the amount in
Salaries Payable is often FORGOTTEN and the entire amount of $4,000 in
this example is debited to Salaries Expense.

V. Accounting for Prepayments: Prepaid (Deferred) Expenses. Deferred

expenses are also called prepaid expenses or deferred charges. A key
letter, “D” and a key word, “Deduct,” to remember with Deferrals as
amounts are deducted from deferrals during the adjusting process to
record correct expenses incurred and revenues earned. With deferred
expenses and deferred revenues, not all adjusting entries can be
reversed as can be done with accrued expenses and accrued revenues.

A. Explain the entries needed when deferred expenses are first recorded as assets.
1. Define deferred expense—advance payment for goods or services that
benefit more than one accounting period. Deferred expenses are actually
Prepaid expenses (supplies, prepaid insurance, prepaid rent, prepaid
advertising, etc.). Deferred expenses have already been paid, but will
benefit future periods. To match (Matching principle) revenue and
expenses properly, a part of the deferred expense must be “put off” into
the future (part that has future benefit) and part must be recognized in the
current period (part that has been used or expired). Be Careful with the
word, “Expense,” as many students get confused thinking that the
account must be an Expense account but the usual transaction is to
record the amounts paid for expenses paid in advance as an asset NOT

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 AN EXPENSE. If the prepayment will become an expense in one year or
less, then the prepaid expense account is listed under the “Current
Asset” section of the Balance Sheet. If the prepayment will become an
expense longer than one year, it is shown in the “Other Asset” section
(long-term section) of the Balance Sheet as a Deferred charge.

2. To differentiate between Accruals and Deferrals, think of the phrase:

“Show me the money!”.
a. With Deferrals, money has changed hands where the money
has been paid in advance BEFORE an expense has been incurred.
With Revenues, money was received BEFORE a revenue has been
earned.
b. With Accruals, money has NOT changed hands where the
expense has not yet been paid by the end of the accounting period but
it HAS BEEN INCURRED. For Revenues: revenues HAVE BEEN
EARNED but the money has not yet been received at the end of the
accounting period.

3. When deferred or prepaid expenses are initially recorded as

assets, an adjusting entry is needed to transfer the amount of the
asset used or expired from the asset account to an expense account.
a. For the initial recording when the cash was paid example: On
October 1, an entry for $3,600 for a one-year insurance policy: debit
to Prepaid Insurance and a credit to Cash.
b. The adjusting entry transfers the amount of expenditure (for
insurance in the example) expired or used to an expense account. To
calculate the amount expired, divide the amount by 12 (months in a
year) and then multiply by the number of months that have expired as
follows: $3,600 ÷ 12 = $300/month x 3 months = $900 expired. Debit
Insurance Expense and credit Prepaid Insurance.
c. The closing entry that closes the balance of the expense account
to the income summary which then becomes part of owner’s equity
for the net income or net loss of the company.
d. Consider the concept of whether a reversing entry will be
considered or not (Reversing entries are introduced in the Appendix,
chapter 4 of the textbook). NOTE that no reversing entry will be
made. Recall the RULE TO MASTER: Whenever an adjusting entry
creates a Balance Sheet account (liability or asset) reversal is possible.
When a deferred or prepaid expense is initially recorded as an asset,
the adjusting process will create an expense account that is closed in
the normal closing routine at the end of the fiscal year. Since NO
ASSET or LIABILITY account was created during the adjustment,
there is no support for a reversing entry.
4. Describe the adjustment for supplies used. The supplies account
will contain the amount that was in the account at the beginning of the
period plus (+) any supplies purchased during the period Example:

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 purchased advertising supplies costing $2,500 on October 5. A debit
(increase) was made to the asset Advertising Supplies. This account shows
a balance of $2,500 on the October 31 trial balance (T.B.). The adjustment
will be the amount of supplies that have been USED. At October 31st, an
inventory of supplies is taken and it is determined that $1,000 of supplies
is still on hand. In order to determine the amount of supplies used, you
must SUBTRACT. THIS STEP IS OFTEN FORGOTTEN and should be
done as follows:
Balance of account on T.B. 2,500.00
- Inventory count (amount on hand) - 1,000.00
= Amount USED (the adjustment) 1,500.00
Assets = Liabilities + Owner’s Equity + Revenues - Expenses
Adver. Supplies Adver. Supplies Exp.
2,500 1,500 USED 1,500
1,000
Note that after the adjusting entry, the balance of the Advertising Supplies account,
$1,000 reflects the amount shown in the inventory count or the amount of the
supplies still on hand. Every adjusting entry affects both the balance sheet and the
income statement. For example, the adjustment for supplies used, the debit is to
Supplies Expense (an income statement account) and the credit is to supplies (a
balance sheet account). This will always hold true.
5. Illustrate the adjustment needed for depreciation of assets .
a. Define depreciation—an allocation process in which the cost of a long-
term asset (except land as land is considered permanent and is assumed
to last forever, so depreciation is not allowed) is divided over the
periods in which the asset is used (useful life) in the production of the
business’s revenue in a rational and systematic manner. The objective of
depreciation accounting is to spread the cost of a long-term asset over
the assets’ useful life, rather than treating the cost of an asset as an
expense in the year of purchase. TYPICAL STUDENT
MISCONCEPTION: in accounting for depreciation, students often
think of depreciation in the economic sense. That is, they view it as a
valuation process used to record the decline in the value of an asset. In
accounting, depreciation has nothing to do with value. It refers only
to the allocation of an asset’s cost over its estimated useful life. As time
passes, the usefulness of assets will decline, and eventually they will no
longer serve their original purpose so the accounting system, must,
therefore, reflect the fact that the equipment and furniture will
gradually wear out or become obsolete and will have to be replaced.
b. Describe the straight-line method of computing depreciation—a
popular method of calculating depreciation that yields the same
amount of depreciation for each full period an asset is used. When
calculating the amount of the adjustment for straight-line depreciation,
you should always calculate a yearly amount first, then a monthly
amount. See example on page 99 of the textbook.

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 c. Describe the contra-account Accumulated Depreciation. The
depreciation adjustment is not reflected directly in the asset account.
Accumulated Depreciation is a contra asset account—an account
whose balance is opposite (offset against) the asset to which it relates.
Since asset accounts have debit balances, contra asset accounts (the
opposite of assets) have credit balances. Contra means opposite or
against like in the words contradiction, contraband, and contrary
(similar to what drawing and expenses do to owner’s equity).
Depreciation is recorded in the Accumulated Depreciation account ,
rather than directly in the asset account, so as to maintain both the
asset account showing the original (or historical) cost of the asset
and the Accumulated Depreciation account showing how much the
asset has depreciated (the total cost that has expired to date). This is
especially needed when the asset is sold to determine any gain or loss
on the sale of the asset. The questions that must be answered on the
tax return are:
1. What was the original cost of the asset? (the amount is
found in the asset account)
2. What is the total depreciation that has been taken on
the asset? (the amount is found in the accumulated
depreciation account)
3. How much was the asset sold for?
4. What is the gain or loss on sale?
The use of a contra account provides disclosure of both the
original cost of the equipment and the total cost that has expired
to date.
The following example illustrates the process of allocating expired (deferred)
prepayments to expenses:
Assets = Liabilities + Owner’s Equity + Revenues - Expenses
Office Supplies Office Supplies Exp.
125 45 USED 45
150
275
230
Prepaid Insur. Insurance Expense
240 20 USED (EXPIRED) 20
220
Office Equip.
3,000
Acc.Dep-Off Eq USED (ALLOCATED) Depr.Exp.-Off. Eq.
50 50
Office Furn.
2,000
Acc.Dep-Off Furn Depr.Exp.-Off.Furn.
USED (ALLOCATED)
30 30

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d. Every adjusting entry affects both the balance sheet and the income
statement. For example, the adjustment for depreciation, the debit is to
Depreciation Expense (an income statement account) and the credit is to
accumulated depreciation (a balance sheet account).

e. Book Value of an asset. Refer to Illustration 3-8 on page 100 of the

text showing the partial balance sheet. Note how the balance sheet
discloses the book value of each asset—the difference between an
asset’s cost and its accumulated depreciation. The book value of an
asset and its market value are not the same. The book value is just the
value that is being shown “on the books,” also sometimes referred to
as carrying value or unexpired cost. Book value is cost minus (-)
accumulated depreciation; market value is what the asset would sell
for. A question that often comes up is: Can a business continue to use
an asset if it has been fully depreciated (book value is equal to zero).
The answer is, YES, because the purpose of depreciation accounting is
to spread the cost of an asset over its useful life. An asset may last
longer than its “estimated” useful life

6. Affect if the adjusting entry for deferred expenses, initially recorded as

assets, is OMITTED:
a. Expenses are understated as did not accrue the additional expense
of Insurance or Supplies Expense. Set up the accounting equation with
simple balances in the accounts if fail to do the adjustment: A = L +
OE + R – E or 200 = 100 + 50 +100 -50.. Expenses are showing a
balance of $50 but the balance SHOULD BE (S/B) $60 as an
additional expense of $10 should have recorded. Therefore expenses
are understated by $10 if the adjusting entry is omitted.
b. Assets are overstated as did not adjust the asset for the portion
used or expired. The accounting equation shows the balances in the
accounts if fail to do the adjustment. Assets are showing a balance
of $200 but the balance SHOULD BE (S/B) $190 as an asset should
have been reduced by $10 for the portion used or expired. Therefore
assets are overstated by $10 if the adjusting entry is omitted.
c. Net income is overstated as did not record the additional expense
of Insurance or Supplies Expense which would reduce the amount of
net income as expenses decrease income and owner’s equity. The
accounting equation shows a net income of $50 ($100 Revenues - $50
Expenses) if fail to do the adjustment. When the additional expense
is recorded the net income is $40 ($100 Revenues - $60 Expenses).
Therefore net income is overstated by $10 if the adjusting entry is
omitted.

7. Explain the entries needed when deferred expenses are first recorded as
expenses.

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 a. There are two ways to initially record deferred or prepaid
expenses (1) as assets or (2) as expenses. Both methods yield the
identical results on the income statement and the balance sheet. A
question usually arises at this point as to WHY would this entry be
initially recorded as an EXPENSE and believe it or not, from an
auditor’s perspective, this is the METHOD that I have observed is
the MORE COMMON method done in practice. Some of the
reasons are:
i. The entry was made by an inexperienced or not
properly educated bookkeeper who believes that any time an
expenditure is made; IT MUST BE AN EXPENSE because
money has been spent and anytime money is spent, it is an
expense with that thinking.
ii. There is actually a conceptual reason for recording this
type of expenditure initially as an expense especially dealing
with the expenditure for supplies. If it is believed that all of
the supplies would be used by the end of the accounting period,
then it would be wise to initially record the amount as an
expense because then it would not be necessary to make an
adjusting entry at the end of the accounting period. This
reasoning does not make sense, though, when paying for an
insurance policy because you would know at the time of the
payment if the policy would totally expire or not by the end of
the accounting period. But if most of the policy will be expired,
then it could be initially recorded as an expense.
b. The adjusting entry that transfers the amount of the
expenditure that is unexpired (insurance in the example) to an
asset account.
c. The closing entry that closes the balance of the expense account
to the income summary which then becomes part of owner’s
equity for the net income or net loss of the company.
d. Consider the concept of whether a reversing entry will be
considered or not. . Recall the RULE TO MASTER: Whenever an
adjusting entry creates a Balance Sheet account (liability or asset)
reversal is possible and desirable as well so that the adjusting entry
into the created account WILL NOT BE FORGOTTEN. Since an
asset account had been created in the adjusting process (prepaid
insurance in the example), a reversing entry is needed to return
the prepayment to an expense in the next accounting period.

VI. Accounting for Prepayments: Unearned (Deferred) Revenues. Deferred

revenue can also be called unearned revenue or deferred credits. End-
of-the-year adjustments are different for the two methods. A key letter,
“D” and a key word, “Deduct,” to remember with Deferrals as
amounts are deducted from deferrals during the adjusting process to

15
record correct expenses incurred and revenues earned. With deferred
expenses and deferred revenues, not all adjusting entries can be
reversed as can be done with accrued expenses and accrued revenues.
Another liability called unearned (deferred) revenue that does not have the word,
"payable," with the name of the account but it is a liability (a debt owed by the
company) as it originates from receiving cash in advance before a revenue
(income earned from carrying out the activities of a firm) is performed. The
reason that this account is a liability is that a service or sale must be made
requiring a performance in the future (a liability as a debt of performance is
owed) or the money must be refunded (a liability as a debt owed) if the job is
not done.

A. Explain the entries needed when deferred revenue is first recorded

as a liability:
1. The initial recording when the cash was received: Debit Cash and
credit Unearned Subscriptions.
2. The adjusting entry that transfers the amount of money received
(for subscriptions in the example) in advance that has been earned to a
revenue account: Debit Unearned Subscriptions and credit
Subscriptions or Subscription Income, etc.
3. The closing entry that closes the balance of the revenue account to
the income summary which then becomes part of owner’s equity for the
net income or net loss of the company. (Closing entries are covered in
chapter 4 of the textbook).
4. Decide whether a reversing entry will be considered or not.
NOTE that no reversing entry will be made. Recall the RULE TO
MASTER: Whenever an adjusting entry creates a Balance Sheet account
(liability or asset) reversal is possible. When deferred or unearned
revenue is initially recorded as a liability, the adjusting process will
create or increase a revenue account that is closed in the normal closing
routine at the end of the fiscal year. Since NO ASSET or LIABILITY
account was created during the adjustment, there is no support for a
reversing entry.

5. Affect if the adjusting entry for deferred expenses, initially recorded

as assets, is OMITTED:
a. Revenues are understated as did not record the additional
revenue earned. Set up the accounting equation with simple balances in
the accounts if fail to do the adjustment: A = L + OE + R – E or 200
= 100 + 50 +100 -50.. Revenues are showing a balance of $100 but the
balance SHOULD BE (S/B) $110 as additional revenue of $10 should
have been recorded. Therefore revenues are understated by $10 if the
adjusting entry is omitted.
b. Liabilities are overstated as did not adjust the portion of the
unearned revenue that has now been earned and should be transferred to

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 a revenue account. The accounting equation shows the balances in the
accounts if fail to do the adjustment. Liabilities are showing a balance
of $100 but the balance SHOULD BE (S/B) $90 as a liability should
have been reduced by $10 for the portion earned. Therefore liabilities
are overstated by $10 if the adjusting entry is omitted.
c. Net income is understated as did not record the additional
revenue that had been earned where revenues increase income and
owner’s equity. A net income shows of $50 ($100 Revenues - $50
Expenses) if fail to do the adjustment. When the additional revenue is
recorded the net income is $60 ($110 Revenues - $50 Expenses).
Therefore net income is understated by $10 if the adjusting entry in
omitted.

B. Explain the entries needed when deferred revenue is first recorded

as revenue.
1. The initial recording when the cash was received: Debit Cash and
credit a revenue account. There are two ways to initially record
deferred or unearned revenues (1) as liabilities or (2) as revenues. Both
methods yield the identical results on the income statement and the
balance sheet. A question usually arises at this point as to WHY would
this entry be initially recorded as an REVENUE and believe it or not,
from an auditor’s perspective, this is the METHOD that I have
observed is the MORE COMMON method done in practice. Some of
the reasons are:
a. The entry was made by an inexperienced or not properly
educated bookkeeper who believes that any time cash is deposited; IT
MUST BE REVENUE because money has been RECEIVED and
anytime money is RECEIVED, it is revenue with that thinking.
b. There is actually a conceptual reason for recording this
type of expenditure initially as revenue. If it is believed that all of the
revenue will be earned by the end of the accounting period, then it
would be wise to initially record the amount as revenue because then
it would not be necessary to make an adjusting entry at the end of the
accounting period. This reasoning does not make sense, though, when
receiving cash for subscriptions because you would know at the time
when the cash is received whether all the subscriptions will be sent or
not by the end of the accounting period. But if most of the
subscriptions will be sent, then it could be initially recorded as
revenue since the interim financial statements would be showing
closer to revenue that will be or has been earned.
2. The adjusting entry that transfers the revenues unearned
(unearned subscriptions in the example) to a liability account: Debit the
revenue account and credit the Unearned Subscriptions.
3. The closing entry that closes the balance of the revenue account to
the income summary which then becomes part of owner’s equity for the

17
 net income or net loss of the company. (Closing entries are covered in
chapter 4 of the textbook).
4. Decide whether a reversing entry will be considered or not. Recall
the RULE TO MASTER: Whenever an adjusting entry creates a Balance
Sheet account (liability or asset) reversal is possible and desirable as well
so that the adjusting entry into the created account WILL NOT BE
FORGOTTEN. When a deferred or unearned revenue is initially
recorded as revenue, the adjusting process will create or increase a
liability account (some unearned revenue account—unearned
subscriptions income in the example) and since a liability account had
been created or increased in the adjusting process, a reversing entry is
needed to return the prepayment to revenue in the next accounting
period.

VII. Summary of Deferrals.

A. Deferrals always result in a DEDUCTION. You will always be reducing

what already happened. The final amount of expense or revenue that is shown
in the expense or revenue account will always be less than the dollar value that
you started to work with.

B. There are always two methods to account for deferrals. However, though
there are two ways of recording deferrals, there is still just ONE CORRECT
RESULT.

IX. Accounting Records Formats for Adjusting Entries.

A. General Journal showing adjusting entries:
1. The caption, “Adjusting Entries,” is entered on the first line
opposite the year of the adjusting entries. This caption helps to inform
the readers of the general journal that the entries that are following are
the adjusting entries—entries made at the end of an accounting period to
insure that the revenue recognition and the matching principles are
followed which bring the account balances up-to-date.
2. Explanations are OPTIONAL if you use the caption at the
beginning of the adjusting entries, “Adjusting Entries,” as this is all that
is needed to inform the readers that the entries following are the
adjusting entries at the end of the accounting period.

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 B. General Ledger:
1. The words “Adjusting Entry” are entered into the Explanation
column which again alerts the readers of the general ledger that these
entries were made at the end of the accounting period to bring the
balances of the accounts up-to-date.
2. The date transferred from the general journal shows that the
entries were made the last day of the accounting period.
C. Preparing the Adjusted Trial Balance:
1. It proves the equality of the total debit balances and the total
credit balances in the ledger after all the adjustments have been made.
2. The accounts in the adjusted trial balance contain all the data that
are needed for the preparation of the financial statements except for the
capital account that may have additional investments in which case that
information would show in the general ledger account.

D. Preparing Financial Statements:

1. The income statement is the first prepared from the revenue and
expense accounts where the numbers are entered from the adjusted trial
balance with the adjusted account balances.
2. The statement of retained earnings shows the net income (loss)
from the income statement and dividends that have been declared.
3. The balance sheet is then prepared from the asset and liability
accounts and the ending retained earnings from the statement of retained
earbubgs.

Retake opening Quiz and then check your answers as follows:

1. True
2. False. The cash account NEVER appears as an adjusting entry.
3. True
4. (1) Accrued expense
5. (4) Deferred revenue
6. (3) Deferred expense
7. (2) Accrued revenue
8. (3) Deferred expense
9. (4) Deferred revenue
10. (2) Accrued revenue
11. (1) Accrued expense

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